Owners of certain flow-through entities may qualify for reduced tax rates on qualified business income earned by the entities via the newly enacted Section 199A, part of the Tax Cuts and Jobs Act (TCJA). If you operate as an S Corp, you may be able to take better advantage of these reduced tax rates simply by reviewing the compensation structure of payments to owners. This planning technique must be considered during 2018 and will be relevant as long as Section 199A remains in effect (this provision sunsets in 2026).

Simply put

Section 199A allows for a 20% reduction in pass-through income to certain qualified shareholders (see below). This is an easy way to save money. Simply put, reducing the salary of owners will increase the net income flowing through to the shareholders, thereby lowering the tax rate; for example, if you are currently paying the top rate of 37%, you may qualify for a reduction of that percentage by 20%, resulting in a tax rate of only 29.6%. Furthermore, the profits may not be subject to Medicare tax, resulting in an additional 2.9% savings. As in the past, shareholders should be paid “reasonable compensation,” but this concept is not specifically defined. Your trusted advisor should be able to determine whether you are in the lowest end of the reasonable compensation range in order to achieve the maximum tax benefit. Of course, most people do not want to take home less money, but this can be solved by paying the reduction in salary as S Corp distributions, taking care to ensure that appropriate estimates are paid so that underpayment penalties are not incurred.

Example: A small distributor where the owner historically receives a $400,000 salary that results in $100,000 net corporate income. Without any planning, the owner will pay tax on the salary at normal rates but will receive a 20% reduction in the $100,000 corporate income, resulting in tax being paid on $480,000 ($400,000 salary plus 80% of $100,000). With careful planning, we can reduce the salary to a reasonable $200,000, resulting in a net corporate income of $300,000. The owner now pays tax on $440,000 ($200,000 salary plus 80% of $300,000). This is a significant tax savings.

Now the details

For 2018, if the owner’s taxable income is less than the threshold amount ($315,000 for married filing jointly and $157,500 for other individuals), there are very few limitations.

However, two major limitations will be phased in once taxable income exceeds the threshold amounts, and will be fully applicable once taxable income is above $415,000 for married filing jointly and $207,500 for other individuals. Specifically:

the deduction will not apply to “specified businesses,” e.g., doctors, lawyers, brokers, accountants, etc. (Architects and engineers are exempt from this limitation because they have better lobbyists); and

the 20% reduction will be limited to 50% of W-2 wages (or in the alternative 25% of W-2 wages plus 2.5% of certain property and equipment cost). So, in certain situations, it may actually be beneficial to increase wages.

The takeaway

There are many nuances and uncertainties regarding the application of Section 199A. And while the Treasury will eventually be issuing guidance, diligent business owners and their trusted tax professionals need to become familiar with them now. Speak to your advisor sooner than later to discuss an optimal compensation target for 2018.